Financial Regulation: What Went Wrong?

In 1803, Lazare Carnot began the the study of entropy in thermodynamics

, suggesting that natural processes become disorganized over time, leading to waste and inefficiency. So too, in economics does this now taken-for-granted law seem to be in clear effect: recession's end has thus far led to little change in the regulatory structure of the Fed and other responsible bodies. The notable exception is the bill now before the House which aims to severely curtail the role of the Fed. Opinions on the extent and type of reform necessary are vehement and divisive. Suffice it to say that the US regulatory framework is in need of major overhaul. But what will regulation of financial markets look like, and how effective can it be?

Past precedent points us to the lessons learned after the Depression, when most of the modern financial oversight was established. The Glass-Steagall Act of 1933 prohibited mergers between commercial banks, investment banks and insurance companies, thereby limiting the liability of any single entity to impose systemic risk to the financial system (although it was not passed solely to combat this problem). The Gram-Leach-Bliley Act passed in 1999 repealed this law, enabling mergers like that between Citibank and Traveler's Group to occur legally (though they merged beforehand and were given a temporary waiver until the law was passed) opening up the floodgates for institutions to become large enough that they could pose serious problems were a major crisis to occur. A moral hazard that (in the context of the worst financial crisis in US history) had previously been seen as an obvious problem had started to fall on deaf ears fifty years later.

Another piece of Depression-era legislation which saw its demise in the later part of the century was the Commodity Futures Exchange Act, which limited the number of speculators in commodities so as to avoid artificially induced price changes. Fourteen major financials were able to obtain exemptions and thus distort a market intended for farmers to hedge against sudden drops in demand for their goods, leading to the massive spike in oil prices seen last year. This dramatic increase, coupled with the real estate crisis, made for a deadly combination for the larger economy. There has been no subsequent reining-in of the commodities speculation market, and after the crash earlier this year a slow run-up in oil prices has ensued.

Both of these examples show a clear trend in US economic policy: anti-regulation fervor has culminated in the removal of important financial laws. As loopholes have widened, systemic risk increased to unsustainable levels and caused recession. Some of the measures taken to mitigate the crisis have already been made illegal, such as federal bailouts passed by the legislature (such matters are now the province of the FDIC), but most other reform projects still have loose timetables and fact-finding committees, not bills or recommendations. A consumer protection user is still hard-pressed for traction in Congress, where lobbyists and former financial workers abound. Public opinion will likely be the determining factor in who is regulated and for how long. But these examples from the past show a few areas where it might not hurt to take a long, hard look.

by: Ki Gray

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